Subprime Credit, Illiquidity, Leverage, Contagion and Concentration

There are two popular views that I am seeing among those that are in the media limelight at present regarding subprime mortgages. There may be more, but I will point at James Cramer’s assertions that this is an illiquidity event, and not a credit event, and the assertions of Bill Gross that this event heralds a wider credit event, and soon. Neither are correct in my opinion.

Cramer is in over his head on this topic; if you’ve never been a mortgage bond manager, but only an equity manager, you might view this in a way akin to a short squeeze. The hedge funds that got killed didn’t have enough equity to carry their positions through some market chicanery. There are no credit losses being allocated to the securities at present, and only the 2006 vintage stinks.

Plausible on the surface. My old boss at the Mt. Washington Investment Group would always say, “Liquidity follows credit quality.” Bonds with improving credit quality tend to become more liquid, and vice-versa for bonds with deteriorating credit quality.

One of my biggest professional investing mistakes was buying a gaggle of Manufactured Housing ABS bonds back in late 2001. I only bought bonds in vintages prior to mid-1997, because I knew later credit quality was horrid. I also stuck mainly to AA-quality mezzanine bonds. All of those bonds are still “money good” today, but when the market fell apart due to the horrid 1998 and after vintages, the bonds with relatively good underwriting got taken to the cleaners as well. Money good bonds trading in the 60s? It can happen.

Markets are discounting mechanisms; with asset-backed securities, if the projected losses make it virtually certain that a tranche of a securitization will lose principal, the tranche will quote like the losses have already happened. It doesn’t matter tht the losses won’t allocated for a few years; the tranche will trade at the discounted value of reduced future payments, at a high discount rate, if it trades at all.

The issues with the Bear Stearns funds are future credit issues, which produce present liquidity issues. It gets noticed there first because of the concentration of the risk in the fund, and the leverage employed. This is similar to what happened in 1994, when the prime mortgage market blew up over extension risk. There was no contagion there; many in the bond market absorbed losses from rising rates, but only a few notable players that took on the negative convexity risks in a big way got killed.

Derivatives are funny, or maybe I should say, people using derivatives are funny. Alan Greenspan thought that derivatives spread out the risk, making the system more stable. Nothing could be further from the truth, at least in terms of spreading out the risk. With derivatives, some market players, out of greed, concentrate the risk because they are trying to make a killing. When the negative part of the credit cycle hits, the speculators get destroyed. Contagion happens when the lenders to the speculators face major losses also. In 1998, that was the worry over LTCM.

With derivatives, speculators absorb the losses that previously might have been borne by the banking system. (Now, those speculators could be DB pension plans, endowments, or wealthy individuals, working through hedge funds.) If the banks overlend to these speculators, they can bear risk as well.

My view is that there are a small number of greedy players that hold most of the credit risk from subprime mortgages, and that their ultimate owners have enough capacity to bear losses that there is no significant contagion risk to the debt and equity markets, even if some players are wiped out, and the banks take modest losses.

That said, I would wait awhile to buy any subprime mortgage ABS, even at the AAA level. The market is dislocated, and has not fully realized the true level of losses that will be taken. The same goes for Alt-A loans, and make that a double!

In summary, this will not be a “piece of cake,” but the losses will be concentrated among a small set of investors. As for the CLO market, it will have its troubles, but not yet. Prudent investors will avoid it, but there may be some rallies there in the short run, away from subprime and Alt-A.